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A Field Guide: Understanding Business Risk

February 27, 2015

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I have been in business for almost 30 years and have observed businesses as an accountant, business advisor and business valuator. I believe I can recognize those businesses and those people that will succeed and remain successful. By success I am talking about consistently earning a profit. I think it is safe to say that business success requires sales ability, products or services people need or want, and finally, management skill. It also requires a good intuitive understanding of risk and return. Let’s look at several common business situations.


Common Business Situation #1

You have a restaurant that is doing great. There is a line-up every night, and it is pretty much accepted that you are a restaurant genius. It seems like a no-brainer that you would want to open a lot more restaurants just like it. The benefits seem obvious. But what are the risks? As you would expect, there are lots of risks including quality of product, location, systems management and financing. Although these risks cannot be removed, they can be managed. The high performers start by figuring out where the success comes from, besides just themselves. Next, they carefully determine a way to transfer the successful aspects of that model to a new location. While all of this seems logical, you might be surprised how few business people actually plan for expansion. Why? The first reason would be unbridled enthusiasm and belief in themselves. Second, they are generally experts in their field, knowing what works and what doesn’t. So where is the problem? The problem might be management risk. A larger multi-location organization needs the owner’s entrepreneurial spirit to be shared throughout the organization. This is usually done with formal systems to evaluate the expansion in the first place through written procedures that actualize the owners dream throughout the business. Transferring the goodwill to the next restaurant by giving the same value experience to customers is key.

Although it may not be overtly expressed, investors, lenders, suppliers and quality employees are looking for signs that the organization is more than just a good entrepreneur. They are looking for good management.

Common Business Situation #2

You are a successful fifty-two year old businessman with sales around $1.5 million. After a fair wage to yourself, the company makes $300 thousand EBITDA. A long-time competitor of yours that is doing about the same as you is retiring and has asked if you may be interested in buying his business. He wants $1 million dollars and the bank is willing to lend you $700 thousand. It seems reasonable, but after talking to your wife, she is worried that you can’t afford it, and she does not like debt. She is especially worried where the $300 thousand short-fall will come from.

In this situation, despite the wife’s concerns, there is clearly reason to analyze the opportunity. We would suggest asking for some preliminary financial information and developing a financial model to understand what the combined organization might look like and to show how it can be financed. The risk can be managed with the structure of the deal and with a careful due diligence process. In most cases, there is less risk with a larger business as you can afford to make improvements, hire better people and be a more attractive target down the road.

Common Business Situation #3

Your third cousin is a manager at a successful electronics business. The founder is retiring and will be selling his 100% interest to four managers, including your cousin. Because of your sales background he suggests that you would be a good fit and has asked if you are interested investing in 20% of the business. After careful analysis of the financial records and projections, it appears the return on your investment would be 20% annually. While the investment is interesting, the deal is loaded with risk. You know little about the electronics business, you will be an outsider, you will have little-to-no control on whether dividends will actually be paid and you have no idea whether the customer relationships are all with the retiring owner.

In a situation like this I would advise that there is too much risk without enough information. The story is probably a lot different for the current managers as they know the business, generally working out a way to pay for the business is a deal killer in these cases. Once again through a well-structured process you can get a better understanding of the company and how you might lower your risks.

In each of these cases there is uncertainty. From one perspective, the risk is what allows you to make a higher return. But you have to know what the risks are and how to manage them if the worst scenario comes true. Smythe Ratcliffe Advisory helps business people develop the financial tools to evaluate opportunities and their risks.

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